Tuesday, October 12, 2010

You better watch out for the police...

I've been ranting about the abuse of accounting identities recently so I read with interest an article by Dean Baker about the importance of accounting identities.

However, Dean merely takes the trade deficit = capital account surplus identity and uses it to start on a strange journey to Nutbush. So let's queue up the Bob Seger and follow along:

The basic logical problem stems from the simple accounting identity that national savings is equal to the broadly measured trade surplus. A country with a large trade surplus will also have large national savings. Conversely, a country with a large trade deficit will have negative national savings. These relationships are accounting identities -- there is no way around them.

So far so good, Dean, I'm totally with you. We are far away from the Nutbush city limits. Not sure who exactly denies this identity but....

This brings us to the next part of the story: where trade deficits come from. At a given level of GDP, the main determinant of the trade deficit is the value of the dollar in international currency markets. This is very basic supply and demand. If the dollar is higher in value relative to other currencies then our exports will cost more to people living in Germany, Japan and China.

If a car sells for $20,000 in the United States then the price of this car to people living in other countries will depend on how much of their own currency (euros, yen, or yuan) they must pay to get a dollar. The higher the dollar relative to these other currencies, the more expensive the car is to foreigners. And, the more expensive it is to foreigners, the fewer U.S.-made cars they will buy. This means our exports will fall.

The story works in reverse on the import side. If the dollar is high and therefore buys lots of foreign currency, then imports are cheap. This means that we will buy lots of imports.

Hold on there partner. Not so fast. It is far from clear that the "main determinant" of trade deficits is the nominal exchange rate. There are a lot of countries whose currency is cheap in dollar terms with which we don't have large deficits. Further, the correct measure would be the real exchange rate and there are a bunch of other factors involved as well. Also not too sure what this has to do with accounting identities.

Still I will grant you that an overvalued real exchange rate would work to reduce exports and increase imports, other factors held constant. Not sure who denies this either though....

This brings us back to the budget deficit part of the story. If the United States has a large trade deficit, then it means that net national savings are negative. That is definitional. For net national savings to be negative then we must have either negative private savings or negative public savings (i.e. a budget deficit).

The budget deficit follows from the fact that we have a trade deficit, which is in turn the result of the overvalued dollar. This brings us to the strangely paradoxical behavior of the Washington policy elite.

Ok, now I see what you did there. You made a u-turn, floored the accelerator, and flew right into downtown Nutbush.

Rather than abusing an identity, Dean is abusing logic and economics.

People, there is a huge theoretical and empirical literature about the so called "twin deficits", and the bottom line is there is little consistent empirical evidence that trade deficits cause budget deficits and certainly it is in no way inevitable that they will.

In fact, in the literature I mention above, most authors argue that it's our budget deficit that is causing the trade deficit, and not as Dean Baker is arguing here with no evidence anywhere in sight that the trade deficit causes the budget deficit!

"if one wants to get the budget deficit down, then it is necessary to reduce the trade deficit."

This is way beyond Nutbush and just plain ridiculous.

If we cut spending and increased taxes we could balance the budget next year no matter how large the trade deficit might be. It just wouldn't be a factor.

Dean Baker has graduate level training in economics so, at some level, he himself must know that he's full of it here.

The bottom line, people, is that contra Dean, the value of the dollar has been falling as our budget deficit has been rising. Here's a graph from Mark Perry on the dollar; I don't guess you need a graph to know what's happened to the budget deficit over that same period.

Our huge budget deficit is NOT due to foreign currency manipulation. It's due to the recession and the explosion of spending over the last four years. No amount of identity theft can change that.

1 comment:

Tom said...

Cum hoc ergo propter hoc?

Trade deficits surely have many causes, but the main one must be that people in one country (on net) see another country as a better investment opportunity than their domestic ones or other foreign. So money flows from A to B... What is prosperous country B going to do with this net influx of investment? If only there were a country C, where the investment opportunity was still greater! But, sucks, the people in A would have figured that out, too. So here we are in B, stuck with great piles of cash. I guess we're just going to have to spend it.

Of course, the government of B could erect trade barriers to hamper that spending. In that case, B will become poorer. Keep it up and B won't be such a good investment target; that will "cure" your trade deficit.

The cause of budget deficits is tenured politicians. Re-elect Nobody!